Get set up for the taxman

It is important to tidy up your records to back up any items disclosed in tax returns, because you never know when you will be asked to provide documentary evidence about transactions.
Photo: Louie Douvis

by
Bina Brown

Record keeping can be the bane of an investor’s life but even a basic system can make all the difference to how much tax you pay at the end of the year, especially with capital gains and losses.

With an increased interest in equity markets there is every chance investment returns will focus heavily in 2012-13 year-end tax calculations.

In either case, it is the cost base that counts in determining how much money you’ve made or lost, and the records for that could date back years.

HLB Mann Judd Sydney tax partner
Peter Bembrick
says it is important to keep good records to back up any items disclosed in tax returns, because you never know when you will be asked to provide documentary evidence about transactions.

“This is especially true when it comes to CGT, because the normal five-year time-limit for keeping records does not apply," he says.

For example, if someone bought a rental property in 1995, did major renovations in 2001, and ­eventually sold the property in 2013 for a large capital gain, as evidence of the CGT cost base for the property you may need to provide records covering the original purchase in 1995, the cost of the renovations in 2001, and any selling costs incurred in 2013.

“It’s obviously much easier to deal with this if you have good habits now, rather than having to search for the records later," says Bembrick.

Related Quotes

Company Profile

Keeping track of what you paid for shares could also help with some ­decision-making at this time of year.

Manage capital gains to minimise tax

Prescott Securities adviser
Darren Wright
says there are just as many ­people sitting on sizeable capital gains in stocks such as Commonwealth Bank, as there are capital losses due to several years of volatility on share markets.

“A lot of people don’t manage their capital gains well.

“If someone’s income is going to be low one year, then it may be worth taking some gains off the table in that year," says Wright.

“I know people who have held CBA since the float who are hanging on to the shares and which now represent an in proportionate amount of their portfolio. It is worth managing a portfolio to make sure this doesn’t happen, and avoid having a growing time-bomb of capital gains," he says.

Wright says, in an ideal situation a person on a low- or mid-range marginal tax rate might be able to sell ­parcels of shares and stay at the same tax rate. “If you are on a 30 per cent marginal tax rate and realise $150,000 in capital gains, you could find yourself in a higher tax bracket. But selling small chunks each year might keep you at the 30 per cent rate.

Essentially, a capital gain is added to an individual’s income in the year the investment is sold and taxed at their marginal rate. If the investment is held for more than a year, the tax is on half the ­capital gain.

An individual on a marginal tax rate of 30 per cent would have their capital gains effectively only taxed at 15 per cent.

The Australian Taxation Office has a calculator to help work out capital gains.

Wright is not suggesting exiting equities altogether. “You could convert that money into other investments that are just as good quality, so you don’t lose any opportunities, but you are effectively starting with a zero capital gain," says Wright.

It is equally important to keep track of capital losses, as they can be used to offset any gains. Capital losses, which need to be recorded in an individual’s tax return, can be carried forward for use in later years.

When a capital gain is made in future years, the loss is deducted from the gain.

Play by the rules

Bembrick says realising a capital loss on an investment in the same tax year as a large capital gain on another investment may help cash flow, as the net ­taxable gain may be relatively small.

However, he warns about deriving a large capital gain late in the 2013 financial year, or a large capital loss early in the 2014 financial year, as investors would pay tax on the gain for 2013, while carrying ­forward the 2014 capital loss to future years.

As tempting as it may be to sell shares in a company to create a capital loss, to reduce the tax impact, the ATO takes a grim view of anyone buying back shares in the same ­company, or shares in a similar ­company, soon after.

The ATO tax ruling says a wash sale is the sale and purchase of an asset where these two transactions cancel each other out so that there is no effective change in the economic exposure of the owner to the asset.

It is interested in sell and buy transactions that occur over a “short period" without defining a ­specific time frame.

A transaction deemed to be a wash sale may also attract the income tax anti-avoidance penalty laws.

The other big story on the equities market this year has been the dividends being paid.

When a company pays Australian tax on its profits, it receives franking credits, which are transferred to resident shareholders when dividends are paid, enabling the investor to use them as tax credits.

For a taxpayer on a zero tax rate, including a superannuation fund in drawdown phase, the franking credits convert a pre-tax dividend yield of, say, 4.5 per cent into an effective yield of about 6.43 per cent.

Avoid common traps

To benefit from dividend franking, the shares must be held continuously “at risk" for at least 45 days, not counting the days of acquisition or sale, so ­effectively 47 days.

Individuals on a marginal tax rate of less than 30 per cent, or retirees paying no tax, are the greatest beneficiaries of dividend franking because the full value of the franking credit is returned to the shareholder. For individuals ­paying tax at the highest marginal rate, the franking credit will reduce the individual’s ­taxable income, says Loxton Securities ­principal
Nick Loxton
.

He says one trap for investors who are topping up existing holdings just for the dividend but who plan to sell them once the dividend is paid – a practice known as dividend stripping – is to make sure no shares in that company are sold before the 45-day period is up.

“If you have a core holding in a company and you plan to buy more shares ahead of a dividend payment and then sell them once the dividend is paid, you can’t sell any of the shares until after the 45 days if you want the franking ­credits," says Loxton.

Loxton says the June year end is an ideal time to review an investment ­portfolio.

“Right now people should be looking at what they are holding and whether it is going to continue to meet their objectives. If it is no longer trading on the same yield, ask yourself where is the return going to come from," says Loxton.

“Consider the yield against a risk-free rate and also a normal yield expectation from that style of asset.

“Then consider the valuation and determine if it is really more likely to be higher than the trading price to fill the gap in the total return that you expect to receive," he says.

Make rational decisions

Loxton says it is important to leave behind any emotion.

“If you can’t honestly see the upside from a logical point of view, then why should it be in the portfolio? If it’s in loss territory, then take the loss and move on, redeploying the funds to a more ­productive asset.

“If it’s in profit territory, consider taking the profit if the odds of achieving your goals are not well in your favour. You don’t have to sell it all, just bank some profit.

“Consider the after-tax position when taking profit, not the pre-tax. You don’t want to pay tax and ­brokerage for a zero sum gain," he says.

Are you a trader or investor; are your losses deductible?

If the recent improvement in financial markets has led you to successfully actively trade in shares and other securities, then you could be faced with paying more tax than you expect on that income.

If, on the other hand, you made losses from your trading or other business activities, it may be much harder to claim those as deductions against any other income you have earned.

According to HLB Mann Judd tax partner
Neil Wickenden
, the distinction between investing for capital gains and trading as a business is becoming blurred.

“If you are trading actively, you may think you are making capital gains which, for individuals, are taxed on only 50 per cent of the profit. But the ATO may take the view you are conducting a business of share trading and tax the whole amount of your gains," says Wickenden.

“But if you have made losses from trading or other business activities, it is now more difficult to claim tax ­deductions for those losses," he says.

Income not always obvious

The so-called non-commercial loss rules have been tightened so that individuals with other income of more than $250,000 can’t claim tax losses from their trading without ­pre-approval from the ATO.

Working out other income of $250,000 is not straightforward as it includes adding back investment losses and adding on salary sacrifice superannuation contributions and fringe benefits, so it is easier to reach the $250,000 limit than you might think.

Wickenden says if an individual’s other income is less than $250,000, they may be able to claim their losses from activities such as share trading, ­provided they pass one of four non-commercial business activity tests.

There must be: gross assessable income from the trading of at least $20,000 for the year; a taxable profit from the trading in at least three of the five most-recent income years; the use of real property in the business activity worth at least $500,000; or the employment of other assets in the business activity valued at at least $100,000, excluding motor vehicles.

Wickenden says that if share trading is a business, losses made on the sharemarket may be written off against other personal income if an individual does not fail the $250,000 other income test and can satisfy one of the four ­non-commercial business activity tests.

For tax purposes, there are two types of investor loss – one is capital loss, and the other is loss that reduces income or revenue loss. An investor who has made a long-term investment in an equity but then sells out at a loss, incurs a capital loss and this can be claimed only against any capital gains in order to reduce capital gains tax.

However, if that investor is classified as a trader, for example someone whose intention is to buy and hold stock short term to realise a profit on sale, the loss could instead be claimed against other taxable income.

“Someone who regularly buys and sells shares with the intention of making a profit can argue they are a share trader. This is likely to be accepted if shares are turned over within a ­reasonably short time and there is a reasonable volume of trades within a year," says Wickenden.

“Many investors who have tried to benefit from the improvement in the sharemarket this year by frequently changing their holdings, could put forward an argument that they have been trading," he says.

Know when to pay in advance

Wickenden says an investor can hold some shares as a long-term investor, and other shares as a trader, but any records must make the distinction clear. “The records should demonstrate that the different treatment accurately reflects the investor’s actions in relation to the various share parcels. The ATO is likely to query a split that appears arbitrary or merely designed to give the best tax result," he says.

Anyone with tax-deductible debt, such as loans used to acquire investments should consider paying 12 months interest in advance in June.

“Prepaying interest means that it will be deductible in full in the 2013 tax return," says HLB’s Peter Bembrick.

In addition, where taxpayers have deductible and non-deductible debt, they should try to structure the deductible debt as interest-only, so that any principal repayments go first against the non-deductible debt such as your home mortgage.

“However, be wary of any ‘split-loan’ arrangements that are promoted as shifting more of the repayments on a multi-purpose loan facility towards the non-deductible debt as they may not be acceptable to the ATO," says Bembrick. “The safest approach is to keep distinct deductible and non-deductible loans and ensure that any transactions are kept separate so there can be no question on the deductibility of interest on the loans used for investment ­purposes," he says.

Strategy Steps director
Louise Biti
says the downside of prepaying interest in the current environment is the ­prospect of further rate cuts.

“You may get the get benefit of a tax deduction earlier, but on the downside it also means you may lock into a fixed interest rate for the next 12 months. If you think interest rates are going to continue to fall this may not be best option. It also means you need to find the money now to make the payment – so this is a cash flow issue," she says.

Use superannuation to reduce tax

Superannuation remains a key way to reduce tax as well as the most ­tax-effective way to save for retirement, with several government incentives available. Super contributions made by salary sacrifice, up to the contributions cap, reduce income tax.

The concessional contributions cap for 2012-13 is $25,000 which includes the compulsory superannuation ­guarantee.

Once inside super, the investment earnings are taxed at a maximum of 15 per cent and are tax-free once a pension is started. Self-employed individuals can claim tax deductions for super contributions (up to certain limits).

Colin Lewis
, ipac securities head of technical services, says an opportunity may exist for members of self-managed super funds to bring forward a tax deduction that applies for super into one year. Essentially an individual could make two concessional contributions of $25,000 before June 30.

One contribution of $25,000 is allocated to the member’s account this year and the other is held in a fund reserve and allocated to the member’s account in the new tax year but before 28 July.

The member gets a tax deduction of $50,000 while not breaching the contribution cap. And if you are 60 or older next year, this could be $60,000 as the second contribution may be $35,000.

Lewis says by allocating the two contributions to different years the SMSF member is still within limits. This brings forward the tax deduction into this year which may be helpful to ­someone who is under age 65 and not working and wishes to reduce a capital gains tax liability or other investment income in the current tax year.